Deflation or inflation?

The harder they come, the harder they fall one and all.
Jimmy Cliff.

There are currently two contradictory forecasts for the times to come, deflation and inflation. Are rising commodity prices mere speculation, a bubble amongst bubbles that will burst as bubbles do? Will the credit crunch lead to a liquidity crisis that must push prices down? Or is legal tender losing its face-value? Is OPEC to blame for the rising price of crude oil, or should the major central banks be held responsible for flooding the market with “money for nothing”?

Trading in commodities is always a speculative business, as it demands a continual anticipation of future prices. But this also applies to stocks and real estate. And these, as shown by recent events, can inflate without inflating currency. However, the price of stocks and real estate only affects the price of stocks and real estate, whereas the price of commodities affects the price of just about everything else. It is also true that company shares and land are practically eternal, whereas commodities are destined to enter the production/consumption process. A barrel of oil is not continuously coming back on the market to be bought and sold. At some stage its value is determined once and for all (without, of course, prejudicing the price of future barrels of oil). Commodities and their value are destined to be consumed and must be produced again. Company shares (as long as the company exists) and land (a part of the Earth’s surface) cannot be consumed. Their market value may fluctuate but their material existence persists unchanged. The persistence of stocks and real estate allows the formation of speculative bubbles that drain money from other employment, but do not otherwise affect the prices on the market. Whereas inflated commodity prices inflate all other prices.

The direct effect of a liquidity crisis is that banks hesitate in lending to each other and to the world at large. This means that the biggest banks will take control of the smaller fry, probably after substantial government bail-outs (vis. Bear Stearns). The next to suffer are the market operators on the stock exchange and in real estate, who need regular injections of extra credit to keep their buoyancy. Then come home-buyers, car-buyers, buyers of sofas and TVs, right down to the ordinary overdraft. Less liquidity means less buying power all round. Will this bring prices down generally, or will it reduce spending to the essentials of life, at whatever price? A shrinking demand for non-essential goods and services will push the weak to the wall, and the big companies will swallow the small.

Like the Roman god Janus, money is two-faced. It can be the intermediary of exchange and it can be the finality of exchange. As K. Marx explained long ago, the perpetual chain of exchanges, commodity - money - commodity - money - C - M - C - M - etc., is made up of two separate series of events. One is C - M - C, and the other is M - C - M. The first series concerns the exchange of goods and services, with money as their intermediary. The second series concerns the exchange of money, with goods and services as its intermediary. Selling the produce of labour to buy the produce of different labour is a consequence of the division of labour. Buying the produce of labour to sell it again at a profit is a consequence of the monetary system. Through the intermediary of money, goods and services are exchanged for consumption (productive or not). Use and exchange value changes hands, and the intervening money is a simple formality. Whereas buying to sell at a profit means that the object of the exchange between money and more money is of secondary importance and that, ultimately, everything is bought and sold.

Buying to sell instead of selling to buy means available credit instead of available goods and services, capital instead of labour. It is no longer the product of labour that is sold to buy the product of other labours. It is labour that is bought, and its product is sold at a profit. And the question arises of the nature of profit. Is labour bought at less than its value, or is the product of labour sold at more than its value? This is a moot-point. But the value of a product is the sum of the values that go into its production, and its market price must cover this plus profit. Profit is the difference between the market price and the production costs. This means that profit depends on a market price that is superior to the value of the product. And profit increases as the gap between price and value widens. If the market price of a product is unchanged (if supply matches demand), and its value is reduced by productivity gains (new technology), or by reducing the price of labour (outsourcing), then profit will increase accordingly. But the exchanges on the market are exchanges of value that do not take into account the difference between an excessive and an insufficient price of labour. The value of labour is the price paid for it. Profit means that the market price is in excess of value, and that the currency measuring the price is devalued. And the larger the profit margin, the more currency is devalued.

In 1973, the Arab members of OPEC decided to reduce their production of oil. This was a reaction to the Kippur War and the occupation of the Sinai. Faisal, the then king of Saudi Arabia who was to be murdered and replaced by his nephew two years later, even declared an embargo on all deliveries to the US. In a matter of weeks, the price of oil was multiplied by four. Arabian light, priced at $2.32 in October 1973, had risen to $9 by January 1974. This led to inflation rates of 10% and more. By 1979 the price of oil had stabilised but, as a consequence of the Iranian revolution followed closely by the Iran/Iraq war, supply was again reduced and prices almost trebled. Inflation rates soared again past the 10% mark. These two “petroleum shocks” were sudden and unexpected, being linked to probable but unpredictable political and military conflicts. Their consequences for oil importing countries were high inflation, recession and unemployment. The present situation seems very similar and the same outcome is likely. This time, however, there are no obvious causes, either political or military, to explain the actual multiplication of the price of oil. The novelty, this time, is that OPEC no longer needs to reduce supply to raise the market price of oil. Not increasing production fast enough is sufficient. And insurgent Iraq seems unable to produce more than it does. Iran is ostracised by several potential customers who refuse to trade. Chavez is doing fine as it is. And other nations (Kuwai,Saudi Arabia, and Nigeria) may have reached their production peaks.

The price of non-renewable commodities is entering a new phase. So far, abundance has been the rule, and this may still be true (1). But the growth curve of supply has been crossed by the growth curve of demand, which is much steeper. Market prices are but a reflection of this new relation, where the planet’s resources are pushed to the limit. However, demand must be solvent, and increasing demand depends on increasing amounts of liquidity. And that seems to be in contradiction with the present situation. Unless liquidity is being drained onto the commodity market, thereby accentuating the lack of liquidity elsewhere. Either demand for commodities slackens and the world economy stagnates or recedes, or this demand is sustained by credit and banks will fall like dominoes. Or, and this is the case so far, central banks change their status of ultimate lenders to that of primary lenders. Instead of backing short term discounting and inter-bank lending, central banks are doing the lending themselves at a bargain rate. This is not quite the same as printing larger and larger denomination bank-notes, because credit returns to the creditor, whereas bank-notes stay in circulation. But the principle is the same. The loans granted by central banks will have to be renewed and increased. Renewed to keep the banks afloat, and increased to compensate the liquidity drawn on to the commodities market. And also to compensate the liquidity that is withdrawn to be consumed. As rising commodity prices are passed on to the consumer, the credit squeeze forces him to fall back on his savings. He too needs cash and must sell his stocks and bonds, maybe even his life insurance or his home. This also must be compensated by central bank loans.

It seems that 2008 will be an up and down year, as central banks regularly intervene on a weekly, monthly and quarterly basis with increasing amounts of credit. The real test will come when governments try to fill their abysmal budget deficits by borrowing on the money market. With banks on the verge of asphyxiation and savings being spent on consumption, this will be difficult and costly and will depend on more central bank lending. Handing out swaths of money at close to zero interest, backed by little or no collateral, may be different from printing bank-notes but the result will be just as inflationary. So inflation wipes out debts and borrowing can increase again, drawing growth along with it. Inflation will greatly alleviate government, corporate and all fixed interest debts. But the holders of these debts will loose out. So will wage earners and fixed incomes in general. And the consequence of these recurrent inflationary peaks is always proportionate to the size of the debt. With inflation, the amount of value destroyed is necessarily a percentage of the total sum of all values.

1. The state of petroleum reserves in the ground is a well kept secret. And may, in fact, be difficult to ascertain. Most sites have been pumping water into the fields for years, to push up the oil. And there is probably no precise way to know how much of an underground reservoir is full of water, and how much is still full of oil. For example, does the Ghawar field in Saudi Arabia still contain more, as much, or less than the 60 billion barrels it has produced so far? http://en.wikipedia.org/wiki/Ghawar

Jumping debts and cyclical borrowing.

Cycles govern most aspects of our environment. The returning seasons, the quarters of the moon and the succession of days and nights are decisive for life on planet Earth. History is subjected to similar periodic phenomena, as empires rise and fall. And business and trade have their own times of growth and slump. And, though the cosmic cycles have given up their secrets and the movements of empire show the historic limits of accumulated power, the cycles of production and consumption, those very human affairs, are still clouded in mystery. What has been studied so far (Kitchin, Juglar, Kuznets, and Kondratieff) is growth in production. This led Schumpeter to conclude that technological innovation was the driving force of growth. And that may be so, but why the cycles? Innovation is an accelerating historical force that can’t be chopped up conveniently into regular slices of time. The cyclical time factor must come from somewhere else.

More supply needs more demand and, hence, more money in circulation. This is done by granting credit, either by lending unspent incomes, or by creating virtual banking money. Credit is granted for investments and for consumption, but only the second case will be considered, that of consumption, of public state spending and private personal spending.

Credit for consumption increases spending to-day and reduces spending to-morrow (when the credit is repaid), unless the credit is constantly renewed. In which case, only the interest is deducted from to-morrow’s spending. An increase in spending due to credit is followed by a reduction in spending, unless the credit and the interest are borrowed again. So past credit and interest are added to the new credit that is maintaining growth in demand. All the credit paid back must be lent out again. And growth cycles in demand are in fact credit cycles.

Credit cycles result directly from successive emissions of treasury bonds. These pay yearly interest, but the value of the bond is only returned at term, in one sum.

A government decides to spend 100 units more per year. To do so, the treasury emits 5-year bonds that pay 5% interest.

The first year = 100

The second year 100 plus 5% interest on the previous year’s borrowing = 105

(Neglecting compound interest)

The third year 100 plus two years interest = 110

The fourth year = 115

The fifth year = 120

But on the sixth year, 125 plus 100, as the first year’s bonds have come to term and must be borrowed again = 225

The “jump” (from 120 to 225) is the turning point in the cycle. It must necessarily cause a slow down in credit growth, as extra funding for an already expanding debt gets more difficult to find. For the usual 10-year and 30-year T-bonds the “jump” is less pronounced, as the sum of interest (x9, x29, instead of x4) accumulated before the “jump” is greater. But the slow down occurs for the same reasons. Government debt, borrowed in the name of the governed, grows and stabilises and grows again, following different time spans. Periodically, the growth and the stabilisation phases of two or more cycles coincide. And the accumulated growth mirrors the magnitude of the ensuing slump.

Public borrowing by states (cities, counties, etc.) depends on unspent incomes. Government debt circulates money that would not do so otherwise, it makes use the nation’s (the world’s?) savings. Private borrowing by individuals is not able to raise funds with bonds, and must depend on banking credit. Individual debt circulates promises of future payments. It creates more money and increases demand. But, as the rules of private borrowing are different, there are no particular turning points.

Consumer credit and mortgages are usually paid back piecemeal. This means that the amount of renewed credit increases faster, but that there is no “jump” at the term of the debt. For example, a 5-year mortgage at 5%, paid back in five instalments, for a growth in spending of 100 per year, gives a progression of credit something like this:

100, 125, 155, 190, 235, 285, 330, 380, etc.

The amounts paid back (that must be lent out again) increase rapidly. And the necessary lending out of ever larger amounts seems to explain the actual debacle of sub-prime loans. Private borrowing also has a variety of time scales, and these regularly coincide. So mortgages and consumer credit just pile up as high as they can. Whereas bonds are cyclical, as the value emitted must “jump” at each term. The two interact however, as both increase demand for consumption and, thereby, sustain investments and employment. And, at regular intervals, a privately cumulated borrowing bubble coincides with a publicly cumulated borrowing “jump”. That seems to be happening at present, as it did 57-odd years ago at the start of the Cold War. And each time around, the dimensions of the event are multiplied.

Another cumulative factor is the gradual synchronisation of the world’s markets in the emission of treasury bonds. Different nations used to have their “jumps” at different points in time. Though the imperial nations had synchronised their dominions and had already magnified growth and slump. Then, the USA being the only solvent nation after WW2, the international monetary institutions were all backed by the US dollar and this synchronised borrowing in the Western sphere of influence. The Soviet and Chinese markets and their satellites tried (with decreasing success) to manage on their own until the early 90s. Since then, all is one and one is all.

It is difficult to grasp the sheer dimension of what is happening. There is no precedent or equivalent to this one-world system of finance and trade. That we all inhabit the same space ship is becoming ever more obvious, as the effects of climate change become apparent. At present, financial synchronisation has also become global but, as with emissions of carbon dioxide, government borrowing is still considered a national prerogative. And, just like greenhouse gases, borrowing is really an integral part of the technological and ideological system that rules all existence on this planet.